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Sell This Stock. Now.

Thu, 27/11/2008 - 12:55 by Nick Kapur

A little more than a year ago, I sat down with the CEO of what used to be a $1 billion company -- a well-known business that I can almost guarantee you've heard of. Here are some of the highlights of the conversation:

"We have to invest year after year to maintain our competitive advantage."

Ouch.

"There's little that we do that no one else can do."

Are you kidding?

"We continually have to adjust for some kind of 'vaporization' effect with respect to our write-offs."

Agghhhh! %$)(@ no!

Out of journalistic considerations, I can't tell you the name of the stock. But the simple truth is that since the interview, shares have dropped 80% anyway -- so people are definitely getting the picture.

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Dime a dozenYou might be able to find the stock if you looked hard enough. Actually, you could probably find dozens more in a similar predicament. While I thought the exec honorable for his candid truth telling -- a big plus in my book -- it's not good enough for any investment of mine. The point here is universal: If the person I interviewed sounds anything even remotely like the CEO of a company in your portfolio, dump that stock. Now.

A lasting competitive advantage is a vital element of a great business. Without it, a company's brief edge in sales or technology or whatever will disintegrate like a finely built sand castle on the beach.

Remember when all your Internet search needs were handled by access providers like Time Warner's (NYSE: TWX) AOL? Soon, enhanced search engines popped up like metacrawler, ask.com, and Yahoo!(Nasdaq: YHOO). Eventually, Google came in to steal the show -- and that was only a few years ago.

You see, this is a business in constant flux. None of these companies has consistently held a significant defensive moat. The point here? Once consumers are able to identify a superior product, nothing stops them from flocking to it. Even successful foreign search properties like Baidu.com(Nasdaq: BIDU) -- despite their massive user bases -- will have to address this fundamental problem at some point, if they want to be long-term players.

A deadly trapNo matter how good a product or a service is, if it can be replicated by others, it's not worth much. In time, competitors will squeeze margins, batter revenue growth, and produce a red ocean of competition. The company will need to invest more and more each year, only to receive a smaller piece of the earnings pie in return.

That's precisely why a company like Intuitive Surgical has delivered greater-than-700% gains in the past five years. No one is even close to replicating the company's Da Vinci technology.

And it explains why companies like Boeing(NYSE: BA) and Airbus continually fight an expensive battle for market share and industry supremacy. Clearly, the whole mystery of large-scale flight isn't stumping too many engineers -- so the secret to success for them these days includes squeezing margins as much as possible, and seizing lucrative contracts. That puts a lot of pressure on a business model.

Instead, examine businesses like Walt Disney(NYSE: DIS) and Johnson and Johnson, which own incredibly valuable intellectual property that consumers clamor for, generation after generation. Assets like these create significant defenses against lower-cost producers and upstarts new to an industry.

Investing legends will tell you the same thing. Among others, Warren Buffett has made billions identifying companies that leverage products or brands whose edge was not in danger. UnitedHealth(NYSE: UNH) and Washington Post(NYSE: WPO) come to mind specifically. Buffett's track record confirms that looking for these types of businesses is a fundamental characteristic of a successful long-term investment.

Back to the horror storyI knew going into the CEO interview that I didn't really like the company's position in the industry. So when I got a sense that he was willing to talk, I pushed harder. I asked him whether the company had any kind of ringer in the pipeline -- perhaps a blockbuster project in one important segment that investors could look forward to. His response?

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